Wednesday, 18 April 2012

Why let private banks create money?


Full reserve banking has two main advantages over fractional reserve. First, money creation by private banks as under fractional reserve is pro-cyclical. Second, fractional reserve leads to a sub-optimum interest rate.


Creditworthiness depends largely on the value of collateral offered. But the value of collateral depends on the stage of economic cycle: e.g. asset prices rise in a boom. Thus during a boom, private banks create money faster than usual: exactly what is not needed.

Conversely, during a recession, the private sector deleverages. That is, the amount of privately created money shrinks. Again, exactly what is not needed. In short, private bank money is pro-cyclical: it exacerbates instability.

Artificially low interest rates and how private banks rob everyone.

A second problem with the private money creation is thus.

Assume an economy where only the central bank creates money, and where the central bank keeps the money supply at a level that ensures everyone spends at a rate that brings full employment.

As in real world economies, borrowing and lending would take place in such an economy: e.g. those supplying goods and services would doubtless allow customers time to pay.

As in real world economies, interest would be charged by creditors for two basic reasons. First, creditors forgo consumption in order to lend, and in consequence they require compensation for that sacrifice. Second, lenders incur administration costs and the costs of bad debts. So interest is made up of the above two items or costs: the “consumption forgone” cost and the “administration plus bad debts” cost.

Now suppose that money creation by private banks is allowed. The beauty of being allowed to create thin air money for private banks is that they can lend without forgoing consumption. That is, administration and bad debt costs apart, private bankers are happy to create money and lend it out at almost zero percent. But of course if you can produce something at no cost, and the existing market price is $Y/unit, you don’t sell at $0/unit do you? You sell at nearer $Y/unit and pocket the difference.

Or as Huber and Robertson (p.31) put it, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves. So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit”.


Moreover, if the economy is at capacity or full employment, the effect of this new money and spending is inflationary. In effect, those in possession of monetary base are robbed. And who benefits? It’s the private banker!

The private banker pretty much takes over seigniorage from the central bank. Printing your own $100 bills or £20 notes is profitable as various naughty printers who have taken to this activity will testify.

Of course there are differences between central bank money creation and commercial bank money creation. Commercial banks create money and HIRE IT OUT. In contrast, the government / central bank machine sometimes GIVES AWAY new money, as in the case of tax cuts. Or alternatively, the new money is spent into the economy in the case of public spending increases.

Inflation can be forestalled.

Having said that private money creation is inflationary (on the above assumptions), an alternative is that government and/or central bank spot the looming inflation and forestall it with tax increase or public spending cuts. But the result is the same: the population at large has to forgo consumption in order to enable the private banker (and shareholders) to INCREASE their consumption.

Interest rate adjustments are inferior to monetary base adjustments.

A possible weakness in the idea that private banks should not create money is that this reduces the effectiveness of interest rate adjustments. That is, as others have pointed out, private banks “lend money into existence”. And interest rate changes affect the amount of lending. Thus if private banks cannot create money, that reduces the influence of interest rate adjustments.

However, there is a VERY LONG LIST of weakness in interest rate adjustments as a method of controlling demand.

First, a very simple and obvious point is that the basic purpose of an economy is to produce what the customer wants (i.e. the private sector consumer and public sector “consumers” – state funded educational institutions, the police, etc). Thus if the economy can be expanded, the way to do it is to give customers more of that which enables them to consume more.

Doubtless interest rate cuts bring stimulus, but why effect stimulus in a way that distorts the price of something: borrowed money? Interfering with the market price of anything leads to a misallocation of resources, unless market failure can be demonstrated.

Second, interest rate cuts are a near farce just at the moment: private sector entities lent and borrowed irresponsibly before the credit crunch and got their fingers burned. They are wary of repeating the mistake. Yet we have the pathetic spectacle of the authorities and reputable economists scratching their heads as to why interest rate cuts are not bringing as much stimulus as is required.

Paradox of thrift unemployment.

A third problem with interest rate adjustments is that debt encumbered money does not deal with paradox of thrift unemployment.

As Keynes rightly pointed out, unemployment will rise if the private sector saves more money: that is, and putting it in slightly more general terms, if the private sector decides it wants more net financial assets, excess unemployment will ensue unless the government / central bank machine provides those extra net financial assets (NFA).

Unfortunately, interest rate adjustments and private bank created money does not supply the private sector with NFA because for every extra money unit (dollar, pound, etc) that private banks create, they also create a money unit of debt. Thus private sector non-bank financial assets do not rise as a result of private bank money creation. They only rise when the CENTRAL BANK creates money, AND SPENDS IT INTO THE ECONOMY. (Note: having a central bank create money and implement QE does NOT change NFA).

Plus, there is disagreement as to HOW LONG interest rate reductions work for: they MAY work as a pump primer, after which rates can be raised. But they may not.

And finally, I listed several other problems with interest rate adjustments here. (Some items on this list repeat some of the above points, but some are in addition to points made above.)

And finally: some quotes.

Abraham Lincoln: “The government should create, issue and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers.”

“The essence of the contemporary monetary system is creation of money, out of nothing, by private banks' often foolish lending.” - Martin Wolf (chief economics commentator at the Financial Times), 9th Nov 2010.

“Of all the many ways of organising banking, the worst is the one we have today” - Mervyn King, governor of the Bank of England.

Milton Friedman on the subject of why we have not adopted full reserve banking: “The vested political interests opposing it are too strong, and the citizens who would benefit both as taxpayers and as participants in economic activity are too unaware of its benefits and too disorganised to have any influence.” (Ch 3 of Friedman’s book, “A Program for Monetary Stability”.)

"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented."
- Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

Milton Friedman: “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.”


  1. Great Post Ralph,

    I was just talking with Cullen and Carlos about a few of these issues.

    I think you've nailed it - we can have private banking, but should we?

    My take is "Yes, but with massive restrictions on what they can do and how much money they can make".

    Your proposal to keep them at 100% reserves seems to take middle ground - very cool.

    We need some way to make sure the private sector has some "vote" on how to expand the economy through speculative credit. But the question is how to do this so it doesn't become overly speculative and feed into the rentier class?

    It's not easy to thread the needle.

    1. My suggestion for threading the needle is thus.

      I’m happy with the private sector “expanding the economy through speculative credit” in that this consists of suppliers giving their customers time to pay. (Although even that activity was controlled in Britain around 1950-75 in that government imposed controls on hire purchase agreements). However, once debts start passing from hand to hand, you have an embryonic or even full blown form of money. That’s what needs to be reined in or even banned.

      Possibly debt factoring should be allowed. But I’d like to see the process whereby private banks “loan money into existence” banned.

  2. I dropped a clanger just above. The fact of buying or selling a debt does not make the debt a form of money. It’s using the debt to purchase goods and services than makes the debt a form of money.


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